ACCT Chapter 1

CH1: The Goals and Functions of Financial Management
1.1 – What is Finance?
 Finance- about making decisions that focus on creating value within the firm and builds upon
the disciplines of economics and accounting.
o Economics- provides theories about economic system and decision making
o Accounting- supplies financial data and data analysis tools.
 Finance has evolved from a pure descriptive discipline through an analytical, decision-oriented
discipline to now a discipline used by financial managers.
 Finance tries to help financial managers to answer (i.e. make decisions about) the following
questions made within a risk-return framework:
o What long-term investments or projects the firm should undertake? (capital budgeting
o How should the firm pay for these assets? By issuing equity or debt? (capital structure
o How much cash or inventory should the firm carry? How much trade credit should the
firm provide or use? (working capital management decision).
1.2 – Goals of Financial management
 Primary goal: shareholder wealth maximization (firm is owned by them)
o Should be measured in terms of market share price, which is a value that investors
collectively are prepared to pay.
 The closest alternative – profit – fails to consider risk and timing and more importantly, it is
almost impossible to accurately measure profit.
 May conflict with interests of management (their compensation) and social/ethical goals.
 Agency theory- potential conflict between shareholders and managers.
 Tradeoffs exist among agency costs of monitoring management actions, allowing sufficient
discretion for management and designing compensation packages to motivate management.
 The goal can be consistent with a concern for social responsibility.
 Firms should take socially desirable actions even if certain actions like pollution control may at
times conflict with this goal.
 Managers should strictly follow the rules of fairness and honesty.
 Insider trading and manipulation of financial results have been proven to serve the
firm/shareholders as well as the management no good.
1.3 – Functions of Financial management
 Some are performed on a daily basis and others are less routine.
 All are carried out with the intention to proper balance profitability against risk.
o Corporate finance
o Banking
o Securities Trading and Underwriting
o Money Management
o Financial Planning
o Risk Management (Insurance)
1.4 – Forms of Organization
 Sole Proprietorship- one owner; largest in actual number but smallest in total sales revenue.
 Partnership- two or more owners
 Corporation- legal entity unto itself; smallest in actual number but largest in total sales revenue.
1.5 – Role of Financial Markets
 Financial markets- vast global network of corporations, financial institutions, governments and
individuals that either need money or have money to lend or invest.
o Public financial markets- for governments to borrow funds for public activities.
o Corporate financial markets- for corporations to raise funds.
 The effect of managerial decisions on the value of the firm is realized in financial markets.
 Structure and Functions of Financial Markets:
o Money markets- deal in short-term securities (less than a year; ex: treasury bills,
commercial paper)
o Capital markets- deal in long-term securities (greater than 1yr; ex: common stock,
preferred stock, corporate bonds, government bonds)
o Primary market- where a firm issues new bonds or shares to raise new funds.
o Secondary market- where investors buy and sell (trade) outstanding bonds/ shares.
Risk-Return Tradeoff
o Increased Profitability = Increased Risk
o Decreased Profitability = Decreased Risk
 E.g. investing in stocks vs. savings accounts
 Stocks may be more profitable but are riskier
 Savings accounts are less profitable and safer
o A financial manager must choose appropriate combination of potential profit (return)
and level or risk (safety).
Securities in Financial Market
o Common Stock (Common Share) = Ownership or Equity
 Shareholders OWN the company
o Bond = debt or liability
 Bondholders are OWED money by company
Financial markets determine value and allocate capital to the most productive use on a riskreturn basis.
Debt is an important component of a firm’s capital structure.
o Too much debt can erode the firm’s cash flow and increases the firm’s risk.
o Interest rates or yields help establish the allocation of capital
o Greater risk increases the spread between inflation and yield
1.6 – Summary and Conclusions
 Finance links economics and accounting
 Primary goal is to make decisions to maximize shareholder wealth.
 However, managers may pursue their own interests instead of those of shareholders.
 Agency theory- studies the conflicts between the shareholders and management.
 Financial managers make investment and financing decisions.
 Financial markets are where financial managers raise funds and are given feedback about the
effect of their decisions.
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